C H A P T E R 11 The Income-Expenditure Model Copyright © 2012 Pearson Prentice Hall All rights reserved Copyright © 2012 Pearson Prentice Hall All rights reserved 11-1 CHAPTER The Income-Expenditure Model 11 Heading into the global recession in 2007, the Chinese economy was growing at the extraordinary rate of 11 percent per year PREPARED BY Brock Williams Copyright © 2012 Pearson Prentice Hall All rights reserved C H A P T E R 11 The Income-Expenditure Model APPLYING THE CONCEPTS How changes in the value of homes affect consumer spending? Falling Home Prices, the Wealth Effect, and Decreased Consumer Spending What evidence does the long historical record provide about multipliers? Using Long-Term Macro Data to Measure Multipliers How influential a figure was John Maynard Keynes? John Maynard Keynes: A World Intellectual How countries benefit from growth in their trading partners? The Locomotive Effect: How Foreign Demand Affects a Country’s Output Copyright © 2012 Pearson Prentice Hall All rights reserved 11-3 C H A P T E R 11 The Income-Expenditure Model 11.1 A SIMPLE INCOME-EXPENDITURE MODEL Equilibrium Output FIGURE 11.1 The 45° Line At any point on the 45° line, the distance to the horizontal axis is the same as the distance to the vertical axis Copyright © 2012 Pearson Prentice Hall All rights reserved 11-4 C H A P T E R 11 The Income-Expenditure Model A SIMPLE INCOME-EXPENDITURE MODEL (cont’d) 11.1 Equilibrium Output • planned expenditures • Another term for total demand for goods and services equilibrium output The level of GDP at which planned expenditure equals the amount that is produced equilibrium output = y* = C + I = planned expenditures FIGURE 11.2 Determining Equilibrium Output At equilibrium output y*, total demand y* equals output y* Copyright © 2012 Pearson Prentice Hall All rights reserved 11-5 C H A P T E R 11 The Income-Expenditure Model 11.1 A SIMPLE INCOME-EXPENDITURE MODEL (cont’d) Adjusting to Equilibrium Output FIGURE 11.3 Equilibrium Output Equilibrium output (y*) is determined at a, where demand intersects the 45° line If output were higher (y1), it would exceed demand and production would fall If output were lower (y2), it would fall short of demand and production would rise Copyright © 2012 Pearson Prentice Hall All rights reserved 11-6 C H A P T E R 11 The Income-Expenditure Model 11.2 THE CONSUMPTION FUNCTION Consumer Spending and Income • consumption function The relationship between consumption spending and the level of income C = Ca + by • autonomous consumption The part of consumption that does not depend on income • marginal propensity to consume (MPC) The fraction of additional income that is spent Copyright © 2012 Pearson Prentice Hall All rights reserved 11-7 C H A P T E R 11 The Income-Expenditure Model 11.2 THE CONSUMPTION FUNCTION (cont’d) Consumer Spending and Income FIGURE 11.4 Consumption Function The consumption function relates desired consumer spending to the level of income Copyright © 2012 Pearson Prentice Hall All rights reserved 11-8 C H A P T E R 11 The Income-Expenditure Model 11.2 THE CONSUMPTION FUNCTION (cont’d) Changes in the Consumption Function FIGURE 11.5 Movements of the Consumption Function Copyright © 2012 Pearson Prentice Hall All rights reserved 11-9 C H A P T E R 11 The Income-Expenditure Model 11.2 THE CONSUMPTION FUNCTION (cont’d) Changes in the Consumption Function Two factors that can cause autonomous consumption to change: • Increases in consumer wealth will cause an increase in autonomous consumption • Increases in consumer confidence will increase autonomous consumption Copyright © 2012 Pearson Prentice Hall All rights reserved 11-10 C H A P T E R 11 The Income-Expenditure Model 11.5 EXPORTS AND IMPORTS (cont’d) FIGURE 11.12 U.S Equilibrium Output in an Open Economy Output is determined when the demand for domestic goods equals output Copyright © 2012 Pearson Prentice Hall All rights reserved 11-24 C H A P T E R 11 The Income-Expenditure Model 11.5 EXPORTS AND IMPORTS (cont’d) FIGURE 11.13 How Increases in Exports and Imports Affect U.S GDP Copyright © 2012 Pearson Prentice Hall All rights reserved 11-25 C H A P T E R 11 The Income-Expenditure Model APPLICATION THE LOCOMOTIVE EFFECT: HOW FOREIGN DEMAND AFFECTS A COUNTRY’S OUTPUT APPLYING THE CONCEPTS #4: How countries benefit from growth in their trading partners? From the early 1990s until quite recently, the United States was what economists term the “locomotive” for global growth • Our demand for foreign products increased • U.S imports increased along with output during this period • The increased demand fueled exports in foreign countries and promoted their growth Studies have shown that the increase in demand for foreign goods was actually more pronounced for developing countries than for developed countries Conclusion: The United States was truly a locomotive, pulling the developing countries along Copyright © 2012 Pearson Prentice Hall All rights reserved 11-26 C H A P T E R 11 The Income-Expenditure Model 11.6 THE INCOME-EXPENDITURE MODEL AND THE AGGREGATE DEMAND CURVE FIGURE 11.14 Deriving the Aggregate Demand Curve As the price level falls from P0 to P1, planned expenditures increase, which increases the level of output from y0 to y1 The aggregate demand curve shows the combination of prices and equilibrium output Copyright © 2012 Pearson Prentice Hall All rights reserved 11-27 C H A P T E R 11 The Income-Expenditure Model 11.6 THE INCOME-EXPENDITURE MODEL AND THE AGGREGATE DEMAND CURVE (cont’d) FIGURE 11.15 Shifts in Aggregate Demand As government spending increases from G0 to G1, planned expenditures increase, which raises output from y0 to y1 At the price level P0, this shifts the aggregate demand curve to the right, from AD0 to AD1 Copyright © 2012 Pearson Prentice Hall All rights reserved 11-28 C H A P T E R 11 The Income-Expenditure Model KEY TERMS autonomous consumption marginal propensity to consume (MPC) consumption function marginal propensity to import equilibrium output planned expenditures savings function Copyright © 2012 Pearson Prentice Hall All rights reserved 11-29 C H A P T E R 11 The Income-Expenditure Model APPENDIX A FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER •Formula for Equilibrium Output Copyright © 2012 Pearson Prentice Hall All rights reserved 11-30 C H A P T E R 11 The Income-Expenditure Model APPENDIX A FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d) •The Multiplier for Investment For the original level of investment at I0, we have For a new level of investment at I1, we have Copyright © 2012 Pearson Prentice Hall All rights reserved 11-31 C H A P T E R 11 The Income-Expenditure Model APPENDIX A FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d) •The Multiplier for Investment Substituting for the levels of output, we have Copyright © 2012 Pearson Prentice Hall All rights reserved 11-32 C H A P T E R 11 The Income-Expenditure Model APPENDIX A FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d) •The Multiplier for Investment Finally, because (I1 − I0) is the change in investment, ΔI, we can write Copyright © 2012 Pearson Prentice Hall All rights reserved 11-33 C H A P T E R 11 The Income-Expenditure Model APPENDIX A FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d) •Another Way to Derive the Formula for the Multiplier y = $1 + ($1 × b) + ($1 × b ) + ($1 × b ) or The term in parentheses is an infinite series whose value is equal to Substituting this value for the infinite series, we have the expression for the multiplier: Copyright © 2012 Pearson Prentice Hall All rights reserved 11-34 C H A P T E R 11 The Income-Expenditure Model APPENDIX A FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d) •Government Spending and Taxes Copyright © 2012 Pearson Prentice Hall All rights reserved 11-35 C H A P T E R 11 The Income-Expenditure Model APPENDIX A FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d) •Government Spending and Taxes Using this formula and the method just outlined, we can find the multiplier for changes in government spending and the multiplier for changes in taxes: Copyright © 2012 Pearson Prentice Hall All rights reserved 11-36 C H A P T E R 11 The Income-Expenditure Model APPENDIX A FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d) •Balanced-Budget Multiplier balancedbudget multiplier (1 − b) (1 − b) 1 Copyright © 2012 Pearson Prentice Hall All rights reserved 11-37 C H A P T E R 11 The Income-Expenditure Model APPENDIX A FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d) •Equilibrium Output with Government Spending, Taxes, and the Foreign Sector output C M y y y[1 y* Copyright © 2012 Pearson Prentice Hall All rights reserved 11-38 ... 11- 21 C H A P T E R 11 The Income-Expenditure Model 11. 4 GOVERNMENT SPENDING AND TAXATION (cont’d) Understanding Automatic Stabilizers C = Ca + b(1 − t)y adjusted MPC = b(1 − t) FIGURE 11. 11... rights reserved 11- 26 C H A P T E R 11 The Income-Expenditure Model 11. 6 THE INCOME-EXPENDITURE MODEL AND THE AGGREGATE DEMAND CURVE FIGURE 11. 14 Deriving the Aggregate Demand Curve As the... reserved 11- 23 C H A P T E R 11 The Income-Expenditure Model 11. 5 EXPORTS AND IMPORTS (cont’d) FIGURE 11. 12 U.S Equilibrium Output in an Open Economy Output is determined when the demand for